Did you know that there are different types of credit, each with pros and cons? It’s important to understand how revolving credit and installment credit work so that you can choose the type that best suits your needs.
What is revolving credit?
Your credit card or line of credit is revolving credit. It is referred to as revolving (or open) because you are able to use it over and over again up to your limit, assuming that you pay down the balance. Interest (Your Annual Percentage Rate/APR) is calculated on your balance in a given billing cycle and applied to your account.
On one hand, revolving credit is very appealing because it is so convenient. However, the easy access that makes it so convenient can also make it a debt that is dangerous to manage.
“An installment loan (like a car loan or your mortgage) is based on a fixed payment every month. Revolving debt payments fluctuate every month depending on your balance, which can make them more difficult to budget for,” says Jeff Schwartz, executive director, Consolidated Credit Canada.
The open-end structure of revolving credit accounts can be particularly problematic for people who carry sizeable balances or who routinely spend beyond their means.
“Not only will carrying a large balance mean that you are accumulating more interest (and ultimately paying more money) using available credit as a means of extending your spending power will ultimately create debt problems. As a rule, use it sparingly,” says Schwartz.
Here are some tips on how to manage revolving credit successfully.
How to use revolving credit
Plan your purchases
You have a budget to establish how to spend within your means every month, right? You need to apply the same idea to your use of revolving credit. Where possible, plan to use cash and then plan to use your credit card for purchases so that you’ll be able to pay off right away. You can even choose to use it only for certain purchases that you’ll easily be able to track and repay.
This is also an excellent strategy if you are working at building a solid credit history.
Don’t pay the minimum only
While your installment loan payments are all you need to pay every month, you are working towards paying down the debt entirely. You can’t treat revolving credit the same way as installment monthly payments. Only making minimum payments makes it extremely hard to pay your balance off when interest accrues.
Most of your minimum payment goes towards servicing interest, leaving very little to actually whittle away at the principle of the debt. Try to pay off the total amount of credit card balances.
Don’t run your credit up to the limit
Avoid paying your credit down and running available space back up again. Not only does this mean that you are creating more and more debt, having your outstanding balance often at (or near) the maximum will lower your credit score. Think of the revolving account as borrowed money. The closure to the maximum amount available on credit cards reflects a restricted cash flow, lowering credit ratings.
Understand how the charges work
Not all credit charges are created equal. Cash advances, for instance, start accumulating interest as soon as you take them out. Don’t use your debit card and your credit card interchangeably. You could be paying extra interest that you aren’t even aware of.
Why is revolving credit good?
The ability to use a revolving line of credit on-demand is the first perk. Using discipline by not running up credit debt will significantly work towards improving a FICO score is the second.
An open revolving credit card with less than 30% credit utilization is a loose indicator of better money management to lenders. Credit bureaus monitor credit utilization percentages on open-revolving credit card accounts. Utilizations are factored into FICO scoring by both credit reporting agencies Equifax and TransUnion.
Even during the Covid-19 pandemic, Canadians have managed to decrease the average consumer balance on revolving credit cards compared to pre-pandemic spending.
A high utilization rate of revolving charge accounts will drop the holders’ credit rating and increase debt over time. Are you struggling to manage your credit card debt? We can help you learn about how different credit products work and your best strategy for paying them off. Call one of our trained credit counsellors at (844) 560-6914 or start with our online debt analysis.